By Steven K. Beckner
(MNI) – Even after allowing for the stimulative effect of the
Federal Reserve’s asset purchases, it may be appropriate for the Fed to
delay raising the federal funds rate from near zero until 2012 if it
follows the kind of monetary policy rule it has in the past, according
to a report from a top aide to San Francisco Federal Reserve Bank
President Janet Yellen, released Monday.
Unless the economy and employment recover more quickly than many
expect, exiting from the Fed’s super-accommodative policy “will take a
significant period of time,” San Francisco Fed senior vice president and
associate director of research Glenn Rudebusch, writes in the Bank’s
Economic Letter,
Rudebusch contends that the risks of tightening policy too soon
outweigh the risks of waiting too long. And he downplays the risks that
a zero rate policy and/or a continued large balance sheet will
exacerbate inflation expectations or give rise to financial imbalances.
Rudebusch writes that eventual rate hikes and asset sales “should
be coordinated,” with the timing to depend on economic variables. But
since there is so much “uncertainty” about their impact, he suggests the
Fed proceed “cautiously” with asset sales and only after first raising
rates.
Rudebusch has been a long-time policy advisor to Yellen, who has
been nominated to replace Donald Kohn as vice chairman of the Federal
Reserve Board. In the past Yellen herself has voiced support for a
longer “extended period” of “exceptionally low” interest rates than some
of her colleagues based on the high level of unemployment and the
negative output gap — the difference between actual and potential GDP.
Nearly a year ago, after Rudebusch had written that the funds rate
might need to stay at zero “for several years,” Yellen told reporters
that was “certainly not outside the realm of possibility.” She has
always said the timing of rate hikes will depend on the pace of growth,
employment and inflation.
Yellen is expected to win easy confirmation in the U.S. Senate and
take over as Fed Board Vice Chairman by the time Kohn is now scheduled
to leave office on Sept. 1.
Rudebusch bases his paper on what he calls a “rule of thumb” which
he says the Fed’s policymaking Federal Open Market Committee has
followed for the past two decades. He says this “simple policy
guideline” calls for lowering the federal funds rate by 1.3 percentage
points if inflation falls by 1 percentage point and by almost 2
percentage points if the unemployment rate rises by 1 percentage point.
The FOMC in fact lowered the funds rate more than five percentage
points in 2007-08, cutting it from 5.25% in September 2007 to between
zero and 25 basis points in December 2008.
But Rudebusch says that “in 2009, as the recession deepened and
inflation slowed, this rule of thumb indicates that — if it had been
possible — another 5 percentage point reduction in the funds rate would
have been consistent with the Fed’s historical policy response.”
And he says the same rule implies the need to keep the funds rate
negative (again, if possible) for another two years.
“To deliver future monetary stimulus consistent with the past —
and ignoring the zero lower bound — the funds rate would be negative
until late 2012,” he writes. “In practice, this suggests little need to
raise the funds rate target above its zero lower bound anytime soon.”
Rudebusch goes further to note that “this implication is consistent
with the Fed’s forward-looking policy guidance (FOMC 2010) that
‘economic conditions — including low rates of resource utilization,
subdued inflation trends, and stable inflation expectations — are
likely to warrant exceptionally low levels of the federal funds rate for
an extended period.'”
Similarly to the FOMC’s policy guidance, he says “the benchmark
policy rule would prescribe an earlier or later increase in the funds
rate if unemployment or inflation rose or fell more rapidly than
predicted…”
However, Rudebusch adds, the FOMC might want to delay rate hikes
even longer because it would be far less difficult to tighten policy
belatedly if needed to do so than it would be to go back to monetary
easing if it turned out that the Fed had raised rates too soon.
“The asymmetric risk associated with the zero bound on interest
rates could potentially lengthen the ‘extended period,'” he writes. “If
monetary policy is tightened prematurely, it would be hard to reverse
course significantly because of the zero bound constraint. However, if
tightening is started late and economic growth exceeds expectations,
there would be ample scope for greater monetary restraint by raising
rates at a rapid pace.”
“The greater risk associated with raising rates too early suggests
postponing an initial increase in the funds rate relative” to the path
suggested by the policy rule as disagrammed in a graph contained in the
paper. (his Figure 1)
Rudebusch is dismissive of arguments for earlier tightening.
In an obvious reference to Kansas City Fed President Thomas
Hoenig’s continuous dissents on the FOMC this year, he writes, “some
have argued that holding short-term interest rates near zero for much
longer could foster dangerous financial imbalances, such as asset price
misalignments, bubbles, or excessive leverage and speculation. The risk
of such financial side effects could shorten the appropriate length of a
near-zero funds rate.”
“However, the linkage between the level of short-term interest
rates and the extent of financial imbalances is quite erratic and poorly
understood,” he adds, noting that the Bank of Japan has held interest
rates at zero for the past decade and a half “with no sign of building
financial imbalances.”
“Therefore, some remain skeptical that monetary policy should
directly aim to restrain excessive financial speculation, especially
while prudential financial regulation remains available for this task,”
he says, citing Kohn’s arguments.
Rudebusch gives much greater credence to the premise that the Fed’s
“unconventional monetary policy” — namely its purchase of $1.75
trillion of longer term securities to lower long-term interest rates —
has reduced the need to hold down short-term rates.
“The additional stimulus from the Fed’s unconventional monetary
policy implies that the appropriate level of short-term interest rates
would be higher than shown in Figure 1,” he writes. “That is,
conventional policy (the funds rate) can do less because of the stimulus
to growth from unconventional policy. In calibrating this effect, it is
important to note that changes in long-term interest rates have much
larger effects on the economy than equal-sized changes in short-term
interest rates.”
He cites research by Boston Fed research director Jeffrey Fuhrer
estimating output is four times more sensitive to movements in the
10-year Treasury note yield than to movements in short-term rates.
“If the Fed’s purchases reduced long rates by 1/2 to 3/4 of a
percentage point, the resulting stimulus would be very roughly equal to
a 1 1/2 to 3 percentage point cut in the funds rate,” he says.
But even allowing for this offsetting effect of unconventional
monetary stimulus, Rudebusch suggests that the “extended period” needs
to last throughout next year and into early 2012.
“Assuming unconventional policy stimulus is maintained, then the
recommended target funds rate from the simple policy rule could be
adjusted up by approximately 2 1/4 percentage points, … and the
recommended period of a near-zero funds rate would end at the beginning
of 2012,” he writes.
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